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The alternative minimum tax: Coping with the AMT iceberg

By Richard Barrington

Think of it as the iceberg of the tax code. And your tax return may be the next Titanic.

The alternative minimum tax (AMT) is like an iceberg because it often represents a hidden danger, and one that can have severely damaging effects. You can be sailing along, thinking you've conscientiously filed your tax return and paid your taxes. Then, BOOM! You get a letter from the IRS, assessing penalties because you failed to pay the alternative minimum tax. You've just hit the AMT iceberg.

If you want to avoid hitting the AMT iceberg, you'll need to know a little background about the alternative minimum tax, and how to cope with it.

Defining the alternative minimum tax

Think of the alternative minimum tax as an alternative tax code, existing outside of normal federal tax brackets and rules. The AMT was created in 1969 to prevent people from claiming so many deductions that they paid little or no tax.

Basically, the AMT is a tax calculation which ignores many common tax deductions, and also ignores lower federal tax brackets for certain types of income, such as capital gains. Your taxable income is re-calculated under AMT rules, and then a standard AMT exemption is subtracted -- $33,750 for single tax payers, $45,000 for married tax payers filing jointly, and $22,500 for married tax payers filing separately. An alternative minimum tax rate is then applied to the remainder -- 26 percent on the first $175,000 for couples filing jointly, and 28 percent on any amount above that.

If calculating your taxes this way results in a higher liability than calculating your tax using standard federal tax brackets and deductions, then you owe the alternative minimum tax.

Coping with the alternative minimum tax

The alternative minimum tax may seem convoluted and obscure, but it is becoming a reality more and more Americans have to deal with. Because AMT exemptions have not kept pace with inflation, what was once a check on high-income tax payers has now found its way squarely into the middle class. The number of people paying the alternative minimum tax has risen from 19,000 in 1970 to the millions today.

Therefore, since you may be the next tax payer to hit the AMT iceberg, you should know some ways of coping with it:

Identify whether you are in an AMT high-risk group. People who are most susceptible to the AMT are those who earn more than the AMT exemption amounts listed above, and claim a large dollar amount of tax deductions and/or have a substantial portion of their income come in the form of capital gains.

Check the AMT assistant. If you believe that you fall into an AMT high-risk group, then a good next step is to try the AMT Assistant for Individuals, an online tool available from the Internal Revenue Service (IRS). By entering some information into the AMT Assistant, you can find out whether you are likely to be subject to the alternative minimum tax.

Fill out federal income tax Form 6251, if indicated. If the AMT assistant indicates that you may be subject to the AMT, then you should fill out federal income tax Form 6251 when you calculate your federal income tax return. This form will walk you through the AMT calculation, and you can then compare the result to your tax liability using conventional federal tax brackets and tax deductions.

Keep a copy of federal income tax Form 8801 handy for next year. If you pay the AMT one year but don't owe the AMT the next year, you may be eligible for a special tax credit. Form 8801 will help you calculate your eligibility for this credit.

The tax code is always somewhat in flux, so check with the IRS and your tax advisor for the latest rules regarding the alternative minimum tax. The more you know, the more you'll be able to cope with the AMT iceberg.

Richard Barrington has earned the CFA designation and is a 20-year veteran of the financial industry, including having previously served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc. Richard has written extensively on investment and personal finance topics.

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